Exelis’ move to spin off company is recent formula used by defense contractors

When Exelis spins off its Colorado Springs-based Mission Systems operations into a separate company named Vectrus, it won't be marching into uncharted territory.
McLean, Va.-based Exelis will become the fourth major defense contractor in four years to spin off its low-profit services...

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McLean, Va.-based Exelis will become the fourth major defense contractor in four years to spin off its low-profit services businesses to focus on higher-margin work. It will follow in the footsteps of Northrop Grumman, L-3 Communications and Science Applications International, which were responding to budget cuts that have hit the Pentagon and the rest of the federal government.

"This is a part of a larger trend in this sector. The service and product businesses are two different businesses headed in different directions," said Byron Callan, a defense industry analyst with Capital Alpha Partners, a Washington, D.C.-based research firm. "This gives them (Vectrus) the opportunity to take down their overhead budget and bid contracts that would not have been palatable to Exelis shareholders because those contracts would have diluted the profit margin of the company."

Once the spinoff happens this summer, Vectrus will immediately become the largest of four public companies based in Colorado Springs with $1.5 billion in annual revenue. It will employ 300 locally and 6,500 others at about 100 locations in 18 countries and may need to add staff in investor relations and other areas that it didn't have as an Exelis subsidiary, but the company also is centralizing other corporate functions to reduce overhead expenses.

Vectrus, a name created by combining the words vector and trust, specializes in managing equipment and providing logistics and supply chain management and information technology and network communication services for the U.S. military.

Exelis focuses on designing and manufacturing a broad array of products that include intelligence, surveillance and reconnaissance systems, integrated electronic warfare systems, networked communications systems, engineering, professional services and manufacturing commercial and military aircraft parts, generating annual revenue of about $3.4 billion.

Exelis announced the spinoff in December, saying it wanted to allow both companies to "become more agile, better aligned and able to more effectively meet the needs of their customers, both domestically and internationally."

"We are repositioning our business to enhance our focus on the long-term growth drivers that will enable us to remain well-positioned in an evolving global market environment," Exelis CEO David Melcher said in a news release.

Cutting overhead costs is key to spinoffs such as Vectrus. Engility, spun off from L-3 Communications in 2012, has restructured its operations twice in the past 15 months to cut its operating expenses by more than a third and enable the company to get into the black last year.

Some of that cost-cutting has begun with Vectrus, which has started centralizing transaction services such as human resources, payroll, paying suppliers and information technology. George Rhynedance, a Mission Systems spokesman in Colorado Springs, said the current consolidation plan calls for moving those services to headquarters as the company wins new contracts or existing work is rebid, resulting in lower costs and "ultimately to provide more attractive prices to our end customers."

But the company will need to try to win new customers and contracts to offset logistics and supply work it is doing in Afghanistan for the Army that will be reduced or phased out as most U.S. forces withdraw at year's end. More than one-third of Vectrus' $1.51 billion in revenue last year was generated from four Army contracts the company holds to manage equipment and provide logistics and supply chain, information technology and network communication services in Afghanistan, according to a filing Exelis made last month with the Securities and Exchange Commission.

"You could see streamlining and cost-cutting initiatives (after the spinoff) as the company pares costs to be more competitive on price to win new contracts," said William Loomis, managing director and defense industry analyst for Stifel, Nicolaus & Co., a St. Louis-based investment banking firm.

Vectrus' revenue declined 17.3 percent last year because of U.S. troop withdrawals from Iraq and Afghanistan, ending a growth trend that boosted revenue by 40 percent since 2009 mostly from major contracts for work in Kuwait, Afghanistan and elsewhere in the Middle East.

Loomis forecast in a research report published in December that Vectrus' revenue likely would "decline for a couple of years beyond 2014 as the $500 million in overseas work declines."

Yet the news isn't all bad for the company: It boosted profits last year by 12 percent from 2012 by reducing expenses nearly 21 percent through "operational efficiencies and favorable contract modifications" on some of its Middle East work. The company also more than tripled its backlog of contracts to $647 million, broadened its customer base with two five-year contracts totaling nearly $1 billion with the Navy and Marine Corps and won prime position on two five-year network communication programs worth about $800 million.

Winning new contracts is a big part of the company's strategy to generate revenue, boost profits and build share value. The strategy also includes expanding its operations to new markets in the U.S., Middle East, North Africa and the Pacific, adding capabilities through acquisitions and seeking more information technology support work.

"As a subsidiary of Exelis, the parent company has not been interested in investing in the business, doing business development, seeking new contracts or making acquisitions," Loomis said. "Now as a separate company, they will have the incentive to invest in the business, make acquisitions and become more efficient."

When the spinoff is complete, Vectrus will be headed by Kenneth Hunzeker, a retired Army lieutenant general who has been president and general manager of the operation since April 2011. Louis Giuliano, former CEO of ITT Corp. and a senior adviser to The Carlyle Group, will serve as nonexecutive chairman. Hunzeker last year earned salary, bonus, incentive pay, stock awards and other compensation totaling $1.33 million, including $81,600 in moving expenses when he relocated to the Springs.

Based on revenue, Vectrus will be more than triple the combined size of the three other public companies based in the Springs - casino operator Century Casinos Inc., Mexican gold mine operator Gold Resource Corp. and medical laser manufacturer Spectranetics Corp.

Exelis, formed in 2011 when it was split off from the industrial equipment manufacturer ITT Corp., meanwhile, will continue to have a big presence in Colorado Springs with 700 employees - even after spinning off Vectrus.

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A Glance at Vectrus (Exelis Mission Systems)

Address: 655 Space Center Drive

Employees: 6,800CQ (doesn’t include 7,250 subcontractors)

CEO: Kenneth Hunzeker

2013 revenue: $1.51 billion

2013 profit: $84 million

Owner: Exelis Inc., but will be split off this summer into separate company with stock traded on New York Stock Exchange

Source: Form 10CQ filed March 10CQ by Exelis with Securities and Exchange Commission